Review of Macroeconomic and
Monetary Developments in 2001-02
3. Recently, the Central Statistical Organisation (CSO) released revised figures for national income growth for the year 2000-01. According to the latest estimates, the growth rate of GDP was substantially lower than earlier estimated, mainly due to downward revision in the growth rate of the services sector. While the growth rate of the services sector was revised downwards from 7.5 per cent to 5.0 per cent, that of agriculture and allied activities was revised from 0.2 per cent to (-) 0.2 per cent. On the other hand, industrial sector growth was revised upwards from 5.3 per cent to 6.2 per cent. As a result, overall GDP growth during 2000-01 was placed at 4.0 per cent on a revised basis as against 5.2 per cent estimated earlier.
4. During 2001-02, according to preliminary estimates by the CSO the growth in agricultural sector is expected to be buoyant at about 5.7 per cent as against a negative growth of 0.2 per cent in the previous year. However, the overall growth performance of the industrial sector at 3.3 per cent is estimated to be lower than that of 6.2 per cent in the previous year. Combined with a reasonable performance of the services sector, estimated to grow by 6.2 per cent mainly on account of trade and transport, finance and business services, the CSO in its latest estimates has projected real GDP growth in 2001-02 at 5.4 per cent as compared with 4.0 per cent in 2000-01. This is consistent with the rate of growth between 5.0 and 6.0 per cent indicated by RBI in the Mid-term Review of October 2001.
5. The domestic inflationary situation during 2001-02 was highly favourable. The annual rate of inflation, on a point-to-point basis, as measured by variations in the wholesale price index (WPI) (base: 1993-94 = 100) declined from 4.9 per cent in end-March 2001 to 1.4 per cent by end-March 2002. Inflation on account of manufactured products (weight: 63.7) registered a decline of 0.4 per cent as compared with an increase of 3.8 per cent in the previous year reflecting sluggish conditions in industrial sector. Primary articles (weight: 22.0) showed an increase of 3.8 per cent as against a decline of 0.4 per cent last year. The moderation in inflation rate has been largely on account of much lower increase of 3.8 per cent in ‘fuel, power, light and lubricants’ group (weight: 14.2) in contrast to 15.0 per cent increase a year ago. The base effect of higher oil prices last year is apparent, as annual inflation measured by increase in WPI on an average basis, worked out to 3.6 per cent as against 7.2 per cent a year ago. Inflation, as reflected by the consumer price index (CPI) was higher on a point-to-point basis (5.2 per cent) as well as on an average basis (4.1 per cent) up to February 2002. Comparative figures for the previous year were 3.0 per cent and 4.0 per cent, respectively.
6. During 2001-02, the annual growth in money supply (M3) was in line with the projected trajectory at 14.0 per cent (Rs.1,83,912 crore) as against 16.8 per cent (Rs.1,89,046 crore) a year ago. Among the components, the growth in aggregate deposits of scheduled commercial banks at 14.3 per cent was lower than that of 18.4 per cent in the previous year during which deposits were augmented by India Millennium Deposit inflows. The expansion in currency with the public was higher at 15.2 per cent (Rs.31,890 crore) as against 10.8 per cent (Rs.20,468 crore) in the previous year. This could partly be attributed to higher agricultural activity and larger procurement of foodgrains.
7. The increase in reserve money during 2001-02 at 11.4 per cent (Rs. 34,514 crore) was higher than that of 8.1 per cent (Rs.22,757 crore) in the previous year. It is interesting to note that the expansion in reserve money was entirely on account of the increase in net foreign exchange assets of RBI which rose by 33.9 per cent (Rs. 66,794 crore) as compared with 18.9 per cent (Rs.31,295 crore) in 2000-01. On the other hand, unlike in the past, net domestic assets of RBI declined on account of both net RBI credit to the Central Government as well as credit to the commercial sector. Notwithstanding RBI’s subscription to fresh government dated securities of Rs.28,892 crore, net RBI credit to the Central Government declined by 0.3 per cent (- Rs.506 crore) due to open market sales of government securities of Rs.30,335 crore. RBI’s claims on banks and commercial sector also showed a decline of Rs.9,575 crore reflecting comfortable liquidity available with them.
8. During 2001-02, non-food credit registered a lower growth of 12.8 per cent (Rs.60,411 crore) as against an increase of 14.9 per cent (Rs.61,176 crore) in the previous year reflecting deceleration in industrial production. The increase in total flow of funds from scheduled commercial banks to the commercial sector during 2001-02 including banks’ investments in bonds/debentures/shares of public sector undertakings and private corporate sector, commercial paper, etc. was also lower at 12.0 per cent (Rs.65,862 crore) as against 16.1 per cent (Rs.75,791 crore) in the previous year. Total flow of resources to the commercial sector, including capital issues, global depository receipts (GDRs) and borrowing from financial institutions was Rs.1,37,429 crore as compared with Rs.1,71,928 crore in the previous year.
9. The increase in food credit at Rs.13,987 crore during 2001-02 was similar compared with Rs.14,300 crore in the previous year reflecting large scale procurement operations. The buffer stock of foodgrains rose to 54.5 million tonnes by end-February 2002 from 46.8 million tonnes in end-February 2001. The carrying costs of holding large buffer stocks beyond an optimal level need to be carefully considered, keeping in view the fact that the outstanding food procurement credit of scheduled commercial banks was as high as Rs.53,978 crore by March 2002.
10. As per the revised estimates in the Budget 2002-03, the fiscal deficit of the Central Government for 2001-02 was placed at Rs.1,31,721 crore as against the budget estimate of Rs.1,16,314 crore. During the financial year 2001-02, net market borrowings of the Central Government at Rs. 92,302 crore (gross Rs. 1,33,801 crore), exceeded the budget estimates by Rs. 14,949 crore and was higher by Rs.822 crore over the revised estimate. The State Governments’ net market borrowings have also increased by Rs. 4,404 crore from the earlier budgeted level of Rs. 12,857 crore. Although the combined slippage in the borrowings of the Centre and States by as much as Rs. 19,353 crore did not exert undue pressure on interest rates because of availability of ample liquidity and depressed credit demand, as emphasised in the Budget speech for 2002-03, there is an urgent need to contain fiscal deficit to improve the task of monetary and debt management from a medium-term perspective.
11. As emphasised in various policy Statements, the overall monetary management becomes difficult when a large and growing borrowing programme of the Government, year after year, puts pressure on the absorptive capacity of the market. Already, the banking system holds government securities of more than 36.5 per cent of its net demand and time liabilities as against the statutory minimum requirement of 25.0 per cent. In terms of volume, such holdings above the statutory liquidity ratio (SLR) amounted to more than Rs.1,40,300 crore, which is higher than the gross borrowings of the Government. Such a large exposure to government securities may inhibit the ability of banks to meet the credit requirements of the productive sectors of the economy, if there is a significant pick-up in demand during the current year. Further, the sustainability of public debt is now a matter of concern, given the increasing interest payments. The reduction in fiscal deficit would impart flexibility to the interest rate regime and, in turn, release government resources for the much needed investment in physical and social infrastructure. Further, fiscal consolidation will also have a favourable effect on inflationary expectations in the economy.
12. It was indicated in the annual policy Statement of April 2001, and reiterated in the Mid-term Review of October 2001 that RBI is committed to maintain adequate liquidity in the market with preference for softening of interest rates to the extent the evolving situation warrants. To this end, despite the high level of government borrowing programme during 2001-02, it was possible to maintain adequate liquidity and a softer interest rate environment without engendering inflationary conditions in the economy. This is evidenced from the fact that the primary market yields on 91-day and 364-day Treasury Bills came down by as much as 262 basis points and 280 basis points, respectively. Simultaneously, the call money rate and weighted average discount rate of CP declined by 156 basis points and 153 basis points, respectively, during the course of the year.
13. There was also a perceptible downward shift in secondary market yields on government securities across the maturity spectrum during the year. The yield on government securities with 1-year residual maturity moderated from 9.05 per cent in March 2001 to 6.10 per cent by March 2002 indicating a reduction in yield by as much as 295 basis points. Similarly, the yield on government securities with 10-year residual maturity had declined by 287 basis points to 7.36 per cent by March 2002 from 10.23 per cent in March 2001. These are among the sharpest reductions in interest rates during the course of a year in the last three decades. However, it needs to be recognised that it may not be possible to reduce the cost of borrowing in the face of higher market borrowings, year after year, particularly when credit demand picks up.
14. In this context, it may be mentioned that while the yields on government securities have declined sharply, those on non-government bonds have witnessed a lower reduction resulting in widening of the spread between these two categories of fixed income securities. Illustratively, the spread between the prime-rated CP and 91-day Treasury Bills widened from 82 basis points in end-March 2001 to 202 basis points by end-March 2002. This could be attributed to greater preference of investors, particularly the banking sector, to seek high quality securities in the face of sluggish growth of industrial sector. The "flight to quality" has been so strong that the yield rate on 10-year government securities had fallen by 287 basis points to reach 7.36 per cent as at end-March 2002. On the other hand, the reduction in deposit rates has been less pronounced with the term deposit rates of public sector banks moving down from a range of 4.0-10.5 per cent for various maturities in March 2001 to 4.25-8.75 per cent by March 2002.
15. The term structure of interest rates reveals that the long-term interest rates have declined more sharply than the short-term rates. For example, in the government securities market, the spread between the yields on 10-year government securities and 91-day Treasury Bills narrowed down from 237 basis points at end-April 2001 to 123 basis points by end-March 2002. While the tenor spread in the government securities market has narrowed reflecting, inter alia, moderation of inflationary expectations, the term spread between highly rated corporate paper and government securities has widened. For example, the spread between AAA rated 5-year corporate bonds and the yield on government securities of equal residual maturity widened from about 65 basis points in end-April 2001 to about 177 basis points by end-March 2002 reflecting, inter alia, an increase in investor preference for sovereign paper.
16. It is necessary to impart greater flexibility to interest rate structure in India consistent with the underlying macroeconomic conditions. Further progress in this direction could be made if banks move over to a variable interest rate structure on longer term deposits as early as possible. Since interest rates could vary in both directions, depending on the phase of business cycle and inflationary outlook, a variable interest rate regime on long-term deposits does not necessarily imply lowering of the average interest rate earned by depositors over a period of time (compared with a fixed rate regime, which favours old deposits over new deposits when interest rates are coming down, and vice versa when rates are moving in the opposite direction). In addition, banks need to reduce their operating costs over time by improving productivity and increasing their volume of lending. This should be possible with proper upgradation of technology in areas which, at present, are contributing to higher costs.
17. In view of the easy liquidity conditions and softer interest rate environment, the overall monetary conditions are at present reasonably comfortable. However, experience of recent years once again confirms that monetary management has now become much more complex than was the case even a few years ago. This is because of several factors, such as the on-going integration of financial markets across the world, the phenomenal increase in financial turnover, liberalisation of the economy, and the rapidity with which unanticipated domestic and international tremors get transmitted to financial markets across the world because of the new technology.
18. It may be recalled that at the beginning of 2001-02, the Reserve Bank had taken steps to ease monetary policy. However, adverse external developments post-September 11 and their effect on financial markets in India necessitated a quick response to provide assurance and stabilise domestic financial markets without tightening monetary conditions. Fortunately, these measures succeeded in stabilising financial conditions without calling for a reversal in the monetary stance. The need for proactive countercyclical policy in the light of emerging situation has also been the experience of other monetary authorities, including the US and European central banks.
19. It is important to emphasise this since, in case the present economic circumstances change, it may again become necessary to take appropriate monetary measures, which may not be in consonance with the present easy liquidity conditions. Keeping these realities in view, it is particularly important for banks and financial institutions to make adequate provisions for unforeseen contingencies in their business plans, and fully take into account the implications of changes in the monetary and external environment on their operations. In this context, in January 2002, RBI proposed that banks should build up investment fluctuation reserve (IFR) to a minimum of 5.0 per cent of their investment portfolio by transferring the gains realised on sale of investments within a period of five years. Banks are, however, free to build up higher percentage of IFR of up to 10.0 per cent of their portfolio depending on the size and composition of their portfolio, with the concurrence of their Board of Directors. Now that the government security prices are high, it may be the opportune time for banks to build up IFR.